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Early seminal work by Krueger (1974) has stimulated numerous studies to examine the phenomenon of PCFs; rent seeking individuals (both firms and politicians) and political intervention becomes a common question in theory and practice. Shleifer and Vishny (1994)have established a theoretical model which shows that there is a trade-off effect in the connection between politicians and connected firms. They argue that politicians may be willing to provide subsidies to firms run by independent managers; but they want firms to pay them back by fulfilling political objectives. In the exchange process there are two effects; the subsidy effect, and the obligation effect on the connected firms. When they have the opportunity to receive subsidies from their related politicians, their firm values will be increased. On the other hand, they have the obligation to pay back these helpers. If the first effect is emphasised the theory is of the “helping” hands group, and if the second effect is the focus the theory belongs to the “grabbing” hands group.

3.2.1 Potential benefits of political connections: “Helping” hands theory

Khwaja and Mian (Khwaja and Mian, 2005) report that political connections help firms preferentially access bank loans, government bailouts (Faccio et al., 2006) and government contracts (Goldman, Rocholl, and So, 2009), which improve their recovery following a

financial crisis (Johnson and Mitton, 2003) and ultimately increases firm value (Fisman, 2001; Ramalho, 2007).

In the study of practical issues, several reports (Fisman, 2001; Johnson and Mitton, 2003; Rozeff, 1982), show that PCFs are more valuable than their less fortunate competitors in developing countries while emphasising that political connections constitute a source of firm value. In particular, Francis, et al. (2009) provide evidence that going public is easier for PCFs. They find greater political exposure is associated with a higher offering price and lower fixed costs over the period of going public. Another example is the recent work Faccio (2010), who has made some cross-country comparisons. It is found that connected firms, using larger bank loans, have stronger market share and pay lower taxes than non- connected firms. Adding to this evidence, Chaney, et al. (2011) and Boubakri, et al.(2002)

show that firms with political connections have lower costs in capital financing than their non-connected peers. All of these studies suggest that potential investors perceive connected firms as being less risky compared to their non-connected peers.

Also, some documents show that political connections have a pervasive impact on the value of public companies even within the confine of a strong legal system. For instance, Morck, Stangeland, and Yeung (1998) show how Canadian firms with political ties benefit from unlimited resources if the government plays a central role in the economy. In addition, Roberts (1990) and Goldman, Rocholl, and So (2009) find an increase in firm value for firms connected with the US Republican Party after the party won the 2000 elections. Ferguson and Voth (1984) provide similar evidence that affiliated firms outperform the stock market by 5% to 8% and account for a large part of the market’s rise.

3.2.2 Potential costs of political connections: “Grabbing” hands theory

However, a series of papers argue that rent seeking and expropriation are important objectives of government intervention (Frye and Shleifer, 1996; Gaver and Gaver, 1993; Shleifer and Vishny, 1994). Further, extensive political entrenchment further affects the cost of equity of the firms. Consistently, Qian, Pan, and Yeung (1995) argue that PCFs can worsen expropriations for at least two reasons: 1) The firm insiders derive gains from their

connections over or above the cost of rent-seeking activities; and 2) connected firms face a lesser concern of capital market punishment due to the easier access to bank loans.

A number of papers have examined the relation between political connections and proxies for firm value and financial performance. Empirically, Bertrand, Kramarz, Schoar, and Thesmar (2006) show that PCFs in France exhibit lower profits than non-connected firms, because entrepreneurs have to bribe presidential campaigners, particularly in election years. Faccio, et al. (2006) provide cross-country evidence that firms with political connections have significantly lower ROAs in the two years following bailouts, indicating a negative effect of political connections on accounting performance. Furthermore, Fisman (2001) concludes that the stock price of firms in Indonesia that are connected to the president dropped more than the price of less connected firms when president Suharto’s health was worsening. Additionally, Johnson and Mitton (2003) find that connected firms underperform compared to similar non-connected firms in terms of market value during a financial crisis.

Political connections are not detrimental only in terms of accounting and stock market performance but also in terms of asymmetry of information for connected firms. Using an international sample, Chen, Ding, and Kim (1995) argue that PCFs experience less accurate analyst earnings forecasts, which suggest that political connections exacerbate the severity of information asymmetry between investors and managers. Indeed, prior research (Ghoul, Guedhami, and Pittman, 2010) shows that the connected firms commonly report lower quality accounting information to hide their expropriation activities and impede efficient monitoring. Additional evidence on the relationship between political connections and information asymmetry is presented by Chaney, et al (2011), who find PCFs have significantly poorer quality of earnings than non-connected firms. These evidences imply that investors view connected firms as more risky than non-connected firms; therefore they are not willing to pay higher prices for connected firms than for non-connected firms.

Another illustration of the cost of political connections appears in Leuz and Oberholzer- Gee (1982) who investigate the relationship between political connections and the likelihood of access to foreign capital markets. They find that connected firms shy away from the international capital markets, due to the higher transparency and scrutiny that are consequences of global financing. They also argue that political connections are less likely

to be a source of long-term value in environments with macroeconomic and political instability as political connections can lose their value overnight when the government fails to win an election.

3.2.3 Political connection research in Chinese firms

While the above studies show the international evidence on the cost of political connections, a growing body of papers use sample firms from China. For instance, Fan, et al., (2007) find that post-IPO stock returns of Chinese privatised firms with politically connected CEOs underperform those without a connection by almost 18%. They also find the boards of connected firms have lower participation by professional directors or managers. To a certain extent, the high involvement with bureaucrats with low professional skills in directorships or management drives the intensity to fulfil political objectives. As a result, such poor corporate governance influences firms’ operations. Furthermore, Cheung, Rau, and Stouraitis (2003) show that minority shareholders in Chinese publicly listed firms are subject to expropriation when their firms conduct related party transactions24with local government shareholders during the period of 2001-2002. The transfer means that substantial-minority shareholders lose up to half of the value of the related party transactions. Berkman, Cole, and Fu (2011) provide additional evidence that regulations aimed at reducing expropriation by controlling shareholders were perceived to be ineffective for firms with strong political connections. The overall evidence from the bove papers is in line with the “grabbing” hands argument (Gaver and Gaver, 1993) that politicians expropriate minority shareholders’ wealth from public firms.

In summary, the results of international studies on political connections are mixed. This study interprets these differences as the reflections of many different types of political connections. Each study is unique in its definition of political relationships; each sample is unique in its political and cultural environment context. In the next section, this study defines a special type of political connection examined in this study; the “princelings” type of political connection. With this in mind, this study develops the following discussion on its major influence on the sample firms.

24Related party transactions are transfers of resources or liabilities between a listed company and the legal